CHANGING VIEWS OF CHINA'S ECONOMY HIGHLIGHTED BY

C O N F I D E N T I A L SECTION 01 OF 03 HONG KONG 000776

SIPDIS

SIPDIS

STATE FOR EAP/CM AND EB
MANILA PASS AMBASSADOR PAUL SPELTZ
TREASURY FOR DAS DLOEVINGER AND OASIA-GKOPEKE
USDOC FOR 4420

E.O. 12958: DECL: 02/24/2031
TAGS: ECON EFIN EINV HK CH
SUBJECT: CHANGING VIEWS OF CHINA'S ECONOMY HIGHLIGHTED BY
HONG KONG SHARE RALLY


Classified By: EP Section Chief Simon Schuchat; Reasons: 1.4 (b/d)

SUMMARY AND COMMENT
--------------


1. (C) SUMMARY: Prices of mainland corporate shares
(H-shares) in Hong Kong, arguably a barometer of market views
on prospects for mainland growth and currency appreciation,
have increased dramatically in recent months, rising 26
percent so far this year. Financial strategists tell us that
the rally signifies three things: greater investor confidence
in balanced economic growth in the PRC; expectations of
renminbi appreciation; and belief in the ability of
higher-quality Chinese companies to manage economic shocks.
Also fueling the rally has been a decision to include
mainland corporate shares in Hong Kong's benchmark stock
index later this year. COMMENT: Placing H-shares in the Hang
Seng Index will not only symbolize Hong Kong's ongoing
economic integration with the mainland, but will also be yet
another concrete step in the ongoing transformation of Hong
Kong's exchange from a local market geared towards bank and
property concerns to a global market with an emphasis on
China plays. END SUMMARY AND COMMENT

UP, UP, AND AWAY
--------------


2. (U) H-shares are the primary vehicle through which China's
state-owned enterprises use stock issuances to sell pieces of
themselves to foreign investors. The 120 H-share companies
that are listed in Hong Kong represent entities incorporated
on the mainland, most of them state-affiliated. China
Construction Bank, the world's largest initial public
offering last year (USD 9 billion),is an example of an
H-share. Such issuances are the primary source of new
business for Hong Kong's exchange and already account for 16
percent of market capitalization. If other categories of
mainland-affiliated firms are added in, then the market
capitalization proportion rises to 39 percent.


3. (U) The principal index for tracking H-shares (the Hang
Seng Mainland Composite Index or HSMCI) has risen 26 percent
this year, a significant rally by comparison with 6 percent
rise for the benchmark Hang Seng (HSI),the index of 33
stocks generally tracked by financial news services when
reporting on Hong Kong; this index does not include H-shares.


FACTORING IN RENMINBI APPRECIATION...
--------------


4. (SBU) JP Morgan Managing Director Grace Ng said that
H-share investors increasingly anticipate significant
appreciation this year of the Chinese renminbi (RMB); Ng
herself predicts a 12 percent upward RMB movement against the
USD. H-share values are rising accordingly, since their
fundamentals are to a great degree valued in RMB. Ng noted a
significant trade-weighted rise in the RMB last year (without
providing a calculation, although another contact has
concluded that there was an 8 percent trade-weighted
appreciation). China will be in a better position to let the
RMB appreciate against the USD in 2006 because the USD is
unlikely to continue its rise against the Euro and Yen. In
other words, Ng is suggesting that RMB-USD appreciation is
easier for mainland policy makers to swallow now because it
is unlikely to exacerbate an ongoing trade-weighted rise
against other global currencies.

... WHICH IS A VALUABLE POLICY TOOL
--------------


5. (C) Further, according to Ng, investors may appreciate
that RMB-USD appreciation is suddenly a valuable policy tool
for officials in Beijing for three reasons. First, the
National People's Congress will be held in early March and
will formally approve the Eleventh Five-Year Plan. This
offers a roadmap towards domestic-focused growth and a more
balanced economy less dependent on exports and investment.
Currency appreciation coupled with maintaining low domestic
interest rates fits in with promoting this scenario. Second,
Congressional pressure from the U.S. and the prospect of
being named a "manipulator" in Treasury's currency report
matters to the Chinese, who do not want the door opened to
unilateral trade sanctions that could harm their economy and
financial markets. (Note: Ng stands out relative to other

HONG KONG 00000776 002 OF 003


contacts here, who believe U.S. pressure could backfire
because the mainland would not want to be seen as bowing to
American demands just as President Hu Jintao is about to
visit the U.S. End Note.) Finally, recent positive growth
figures (e.g., January's surprisingly strong export data)
suggest that China has room to absorb the retarding effects
of appreciation. Confidence in prospects for appreciation
has been only bolstered by faster upward movement of the RMB
seen this month, since the end of the Chinese New Year,
according to Ng.

ECONOMIC CENSUS ALSO HELPS H-SHARES...
--------------


6. (C) Ng referred to China's recent economic census that led
to a 17 percent upward revision of the size of its economy.
The change was primarily a result of recognizing the larger
role played by services than previously thought, suggesting
that the economic forces underpinning the growth of
consumption in wealthier, more urban markets are stronger
than investors had believed. This strengthens the outlook
for at least some of the H-share companies, Ng told us.
Further, signs of sustainability in consumer growth are
suggestive of more stable profit margins. Confidence in the
resilience of these profits coupled with increasing
recognition that the mainland firms listed in Hong Kong are
among the best in terms of corporate governance is another
factor bolstering H-shares, in Ng's view.

... AND GREATER ECONOMIC BALANCE AS WELL
--------------


7. (C) Goldman Sachs Managing Director Hong Liang old us
that the rally represents growing investo confidence in the
ability of China's economy tosustain high rates ofeconomic
growth, but she dew a contrast between market sentiment and
her ow views, which are more pessimistic. Investors, sh
said, are positively reassessing China's macroeonomic
health, and they see an economy tending towards greater
balance with regard to continued expansion generated by
exports, investment, and domestic consumption. There is also
increasing confidence, perhaps misplaced, in Beijing's
ability to manage China's economy in the coming years,
especially given its perceived bias towards stimulating
domestic demand. Investors additionally believe that as the
sustainability of high levels of growth becomes evident to
policy makers, they will grow more comfortable in letting the
RMB appreciate. Liang predicted a 3-5 percent RMB
appreciation this year.

A CAUTIONARY NOTE
--------------


8. (C) Liang said that mainland policy makers might fail to
manage the current economic cycle properly by reacting too
slowly. She thinks that economic activity is understated and
that policy makers are likely to wait until after first
quarter data are finalized to see that this is the case and
then respond. Liang termed China's slow response to the need
for RMB appreciation a "worst case approach" towards
macroeconomic management and asserted that continuing in this
way will lead to inflationary pressures amidst rising
commodity prices. The result will inevitably be "bubbly
stuff somewhere." But by reacting too late, authorities will
find themselves hesitant to prick the bubbles with higher
interest rates out of fears of hurting other sectors of the
economy that need to keep growing. Consequently, they may
once again resort to administrative approaches; such
arbitrary non-market measures could quickly change investor
sentiment.

H-SHARES TO JOIN HONG KONG'S BENCHMARK INDEX
--------------


9. (SBU) H-shares account for a significant proportion of
foreign investor interest in the Hong Kong exchange, yet they
are not represented on the benchmark HSI. They are barred
from the index because the ownership held by state-affiliated
parent firms is often in the form of "non-tradable" shares
that cannot be bought or sold. To reform the Shanghai stock
market, China is presently converting non-tradable shares of
companies listed there (A-shares) to tradable shares. This
will open the way for H-share firms in Hong Kong to join the
HSI for two reasons. First, some H-share firms are also
listed as A-share firms in Shanghai, so the

HONG KONG 00000776 003 OF 003


Shanghai-initiated conversion to tradables affects some
companies listed here and will make them eligible to join the
HSI. Second, Chinese firms that have not yet listed as
H-shares or A-shares will be more inclined to list as fully
tradable the first time around, thus qualifying them up front
for HSI constituent status.

INTEGRATION AND TRANSFORMATION
--------------


10. (C) We note that loading the HSI up with PRC firms
symbolizes Hong Kong's further integration into the
mainland's economy. It will also draw those who invest in
Hong Kong's market away from traditional property and banking
concerns located here and into companies based in the PRC.
This is because fund managers often allocate investments
against a basket of shares like the HSI. Therefore, if the
HSI is weighted less towards companies like HSBC (bank) and
Sun Hung Kai (property) and more towards H-shares like China
Construction Bank and Angang Steel, then foreign funds will
flow accordingly.

Sakaue